It's an understatement to say that stocks were quiet this summer. They were graveyard quiet.
After a hair-raising plunge in the aftermath of the Brexit vote, equity markets bounced back, then settled into a holding pattern that made the past several weeks one of the least volatile periods in recent history.
Canada's benchmark index, the S&P/TSX composite, did not fall by more than 1 per cent on any day in July and August. The same was true for the Standard & Poor's 500, the key gauge of U.S. stocks.
But that calm – or, some would say, complacency – may soon be broken. A market willing to overlook rising risks is one doubly exposed to the next shock.
Right now, the list of risks is long. They include mediocre global growth, a tightening of credit, cracks in the Chinese economy, political strains in Europe, potential U.S. rate hikes, falling corporate buyback activity, Donald Trump and a recession in company profits, which may or may not have ended.
Most of these risks are not new. But they take on new urgency at a time when stocks are trading near record highs and valuations appear stretched. The S&P 500 is just 10 points away from its all-time peak. The TSX, after a strong week, is about 860 points shy of a record.
Over the course of the summer, the ranks of the bearish camp swelled, convinced that stocks have run up too far. Predictions of an imminent correction piled up, several of which were issued by the biggest names in investing, including billionaire fund managers Jeffrey Gundlach, George Soros and David Tepper. Goldman Sachs analysts issued a call at the start of August for investors to underweight equities for the next three months.
Yet this is a bull market well acquainted with skepticism. For nearly as long as it has been kicking, there has been a significant proportion of investors expecting its demise. Two market crashes within a decade will do that.
"Recent experience is a powerful influence," says Craig Fehr, an investment strategist at Edward Jones. "Folks are expecting that's what the next bear market will feel like." Twice bitten, thrice shy.
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That fear has been enough to instill a cautious approach to equities, although it's a bit of a mischaracterization that the average investor has taken a pass on the bull market, according to David Rosenberg, chief economist with Gluskin Sheff + Associates.
Since 2009, the proportion of U.S. household assets allocated to equities has actually risen from 15 per cent to 20 per cent, according to Federal Reserve data.
Recently, the stock market even showed signs of converting some of its more persistent disbelievers. Investors sunk a net $12.6-billion (U.S.) into U.S. equity funds in the week ended July 13, the highest weekly inflow in nearly a year.
This looked like "bear capitulation" to Merrill Lynch's chief investment strategist Michael Hartnett. "Investors … are now stampeding into the asset class for fear of missing out," he said in a note. Merrill analysts recently predicted a "final melt-up" perpetuated by investors chasing returns.
Hedge fund positioning also took a bullish turn, with a net long position of 38,000 S&P futures and options contracts on the Chicago Mercantile Exchange as of Aug. 23. Mr. Rosenberg called that "one vivid sign of just how complacent the masses are."
In mid-August, the Financial Times invoked some troubling precedents in stock market history by citing evidence of "irrational exuberance" in the market today. Coined by former Fed chair Alan Greenspan in 1996, the phrase is a diagnosis reserved for times of dangerous levels of enthusiasm for stocks, such as the dot-com boom of the late 1990s, which ended in a spectacular bust.
But is the equity market really suffering from too much enthusiasm right now?
After a short-lived spike, bullish sentiment among smaller investors fell back to 28.6 per cent, according to the American Association of Individual Investors' latest weekly survey released on Thursday. That marks the 44th consecutive week of sub-40-per-cent readings – the longest such streak since 1987.
That's the legacy of the financial crisis – its victims keep waiting for a replay, said Richard Bernstein, a veteran strategist and chief executive of Richard Bernstein Advisors in New York.
"Sure, some bears are giving up, but not bears in total. Not even close," he said. "Great bull market sentiment."
This is not the typical atmosphere in which bull markets die. As goes the famous quote by Sir John Templeton: "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria."
Valuations provide much of the fodder for the bear case. But as Michael Greenberg, a portfolio manager at Franklin Templeton in Toronto, puts it: "Valuation is in the eye of the beholder."
On a headline basis, trading multiples certainly seem high. The forward 12-month price-to-earnings ratio for the S&P 500 index is nearly 17 times, well above the five-year and 10-year historical averages of 14.7 and 14.3, respectively.
In May, Goldman Sachs published a report showing the median stock's price to earnings in the S&P 500 trades in the 99th percentile relative to the past 40 years. In other words: extremely overvalued. A reversion to the mean could wipe out equity returns for years to come.
Like U.S. stocks, Canadian stocks hardly look like bargains. The forward price-to-earnings ratio is above 16, and analysts warn that bank stocks – one of the few bright spots in the Canadian market given the state of commodity producers – are fully valued and unlikely to juice their dividends in the months ahead. The six largest banks represent about 22 per cent of the TSX composite.
Still, the Canadian index has not risen to such nosebleed heights relative to recent peaks. For example, while the S&P 500 is now nearly 40 per cent above its pre-financial-crisis high, the S&P/TSX composite index sits at about the same level as in the summer of 2008. Also, the heavy weighting of beaten-up oil and mining companies within the Canadian index means that it isn't reflecting exuberance on the part of investors. Despite a modest rebound over the past several months, energy stocks are still down about 30 per cent since 2014 and materials stocks are down more than 45 per cent since 2011, suggesting these areas of the market remain depressed.
And in any event, determining fair value for stocks is particularly tricky in an era of unprecedented monetary stimulus and paltry, or even negative, long-term bond yields. Low interest rates make stocks more attractive relative to bonds and elevate the multiples that investors are willing to pay.
"Bringing in the low Treasury bond rates of the last decade into the analysis dramatically shifts the story line from stocks being overvalued to stocks being undervalued," Aswath Damodaran, a professor of finance at New York University and an expert on valuation, recently said on his blog.
His was not an argument for timing a cheap market. Rather, he wanted to show that "any single pricing metric, no matter how well reasoned it may be, is too weak to capture the complexity of the market."
Rather than valuations, Mr. Damodaran said his main concerns surround earnings and corporate share buybacks, which have helped to propel stocks higher. Since 2009, S&P 500 companies have bought back more than $2-trillion of their own shares, reducing outstanding share count and handily beefing up earnings-per-share results in the process.
"U.S. companies cannot keep returning cash at the rate at which they are today," he wrote. "Unless earnings show a dramatic growth – and there is no reason to believe that they will – companies will start revving down their buyback engines and that will put the market under pressure."
More than 100 per cent of the collective profits of S&P 500 companies were returned to shareholders last year. The trend is already starting to slow.
U.S. buybacks were down 21 per cent in the first seven months of 2016 compared to last year, according to TrimTabs Investment Research. Some analysts have begun to speculate that the buyback trend has reversed.
Even though money borrowed at cheap rates has been used to fuel some of the buyback boom, the hangover from the profits recession could limit the amount of funds U.S. corporations are willing and able to return to shareholders.
For five successive quarters, S&P 500 profits have declined year over year, as the strong U.S. dollar and low oil prices have put the squeeze on Corporate America.
But the improving trends posted in the latest earnings season were enough for Ed Yardeni, president and chief investment strategist at Yardeni Research, to call a bottom. "The earnings recession is over," he said in a recent note.
However, the profit outlook could again deteriorate.
For Mr. Fehr of Edward Jones, the overall threats in the market don't appear disproportionate. "Relative to the past seven years, we're probably in an environment when the balance of risk and opportunity is most level," he said.
For most of the course of the bull market, now in its eighth year, the balance has tilted more toward opportunities, making index investing a lucrative approach. Generating returns in the next phase of the bull might best be achieved by picking winning sectors and companies.
This nearly equal balance of risks and opportunities suggests the market will see corrections with more regularity than investors have grown accustomed to.
"The rising tide has lifted all boats. The next leg of the bull market will bring the need for more focus on the specific companies you're buying," Mr. Fehr said.
With files from reporter David Berman